True Economic Condition Far Weaker, Market Valuation Reaching Peak

Includes: DIA, IWM, QQQ, SPY
by: Carlos X. Alexandre


Home and auto sales not as good as they look.

S&P 500 reaching for the climax.

Economic sub-cycle entering a contraction phase.

After an expensive education, I made a conscientious effort of letting my economics courses fade from memory, because after many years of comparing theory after theory with the real world, I was dismayed that I actually paid for something so useless. I would have been better off if I had spent the money on cheeseburgers, fries and beer, for I would have some fat to show for it. There is a very good short video titled "When The Herd Turns," a free eight-minute lesson that summarizes economics, the simple ins and outs and the dumbness of experts. To add validation to the video, Charles Plosser, the president of the Federal Reserve Bank of Philadelphia, summarized the Fed's ineptitude via a few wise words in the midst of nonsensical and useless rhetoric.

"If you study the Fed over the years, over its history, it's always behind the curve."

Considering that the Fed's mandates are very specific and minimal -- maximum employment, stable prices, and moderate long-term interest rates, and we don't know what maximum, stable and moderate actually mean -- it is disheartening that they simply cannot do it, time and time again. Yet, everyone listens to their speeches as if they were gospel, and are mesmerized by their meaningless dots (keep a current copy for future reference and amusement), similar to engaging a heart surgeon to operate on you even though you know that the surgeon's success rate is zero. But here's the revelation of the century:

Uncertainty about the direction of the U.S. economy has been associated in recent years with weaker growth, at least in part because the Federal Reserve has kept short-term interest rates pinned near zero, argues new research from the Dallas Fed.

Do you think? I've been mocking the Fed for a long time, and every time I want to find something useful that emanates from that beleaguered institution, another study about the obvious pops out, further reinforcing my criticism. But let's overlook the Fed's own research, as Minneapolis Fed President Narayana Kocherlakota projects a complete lack of faith.

The Federal Reserve should keep U.S. borrowing costs low for another five years to ensure the economy returns to health

Economic numbers are nothing new, but seldom are they put in context, or as the French would say, "mise-en-scène." They're wonderful for the immediate trade waiting in the wings, regardless of direction, but they don't say much on their own, not to mention the discrepancies that spring along the way. As an example, the National Home Builders Association has been reporting contraction in home traffic for five straight months, yet new home sales jumped over 18% in May to an annual rate of 506,000, which is still 50% below the norm. Then, the National Association of Realtors insinuates that if existing home inventories were higher, sales would excel. But if inventories are lower, that should be a shot in the arm for new homes. This is what we have to work with, the spin is often too tangible to be ignored, and critical thinking is of the utmost importance.

The home sales raw number by itself is very misleading, and when taking population into account, the picture becomes clearer. As the chart above shows, total home sales (new and existing) are about 40% below the peak in 2005, and 20% below the total in 2000, when monopoly money was still available. Meanwhile, population continues to grow, and while there were 35 persons per home in 2000, and 25 persons per home in 2005, the ratio now is still 45 persons per home. Accounting for the fact that the home buying stimulus delivered by private equity has now ceased, while we've had the lowest mortgage rates in decades, where exactly are we heading when wages are stagnant, if not declining?

Auto sales, the other big-ticket item and also easier to acquire, have benefited from longer-term loans, an increase in leases, and the revived subprime lending, a further indication of a poor economic environment, where every dollar is stretched to the maximum. When population is brought into the equation, we now have 15 persons per car, an improvement from the 19 persons per car in 2009, but still short of the 12 persons per car in 2000, even with all the financing adjustments listed above. The recent April reading on consumer credit showed the largest jump since 2000, and I'm betting that something is amiss and extremely abnormal, because credit card usage rose in one month as much as the previous 17 months… combined!

Between the Fed's endless fiddling with the markets through its magic wands, corporate stock buybacks and cost-cutting, we have market records galore, and the question is how does the cost-cutting (read lower wages) feed sales? It's not as if the U.S.A. can count on exports like the other suspects, and common sense tells a 5th grader that the condition is unsustainable. The other question is, when will market participants realize the true condition of the economic engine? The answer is always elusive, until the numbers can no longer be explained away by weather conditions and other tales.

Let's not forget about M&A (mergers and acquisitions) and the often irrational premiums that go with it, rewarding some and sticking others with expensive stock certificates. The point here is that those making those decisions are seldom left holding the empty bag, while cashing in their chips before the crowd wakes up. Here's an article published in 2008 that sheds light on the subject.

Things haven't necessarily changed since 2002, when Alfred Rappaport, then a professor emeritus at Northwestern University's J.L. Kellogg Graduate School of Management, wrote in a column for The Wall Street Journal that buyers typically overpay for the companies they target, due partly to being overly optimistic about cost-cutting opportunities and their superior management capabilities. Rappaport said that two-thirds of acquiring companies see their stock prices immediately fall upon news of a deal, a drop that "usually corresponds" to performance of such stocks over the next year. The "sobering facts" about mergers and acquisitions, he wrote, are that "a majority of them don't work."

While this market continues to be tweaked and unduly influenced by the Fed, it has become a certified joke to imply that historical economic measuring sticks apply here.

The debate continues regarding a number of market valuation measurements, and the top line is still my favorite, because "adjustments" are far more difficult to make. The S&P 500 (NYSEARCA:SPY) price/sales ratio is approaching the high mark last seen during the fiesta, although back then, the Fed wasn't drinking tequila shots. But let's keep in mind that the last time the market dropped, common folk could easily establish the link with the housing debacle and its ramifications. What about the next time when the much advertised and promised recovery fails to materialize? Dismay, confusion and personal protectionism will ensue, with all the economic side effects.

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Money's velocity is that background and somewhat silent statistic that is often overlooked when analyzing the effects of the almighty QE, and the explanation, courtesy of the St. Louis Fed, is as follows.

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.

Well, if one hasn't noticed, velocity of money is not increasing, while the cost of money is as low as it has ever been, and we shall salute the experts on their projections.

Lastly, and according to the Generational Economic Cycle's sub-cycle, we're now entering a U.S. economic contraction phase starting in July, along the same lines as 2006, and time will determine whether the theory holds water or is just vapor. Then, in addition to run-of-the-mill economic cycles and issues, now the civilized world must deal with the uncivilized "jihadiots," and to fully address the problem, it must be done in a definitive manner that will alter the course of humanity, because that is exactly what they have in mind, and, unfortunately, diplomacy is not in their manuals or an option.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.